In situations where a bankruptcy court avoids a fraudulent transfer or similar transaction, subsequent transferees who received proceeds of the avoided transaction from the initial transferee can avoid liability in certain circumstances. Specifically, section 550(b)(1) of the Bankruptcy Code provides that the plaintiff in an avoidance action “may not recover” from a subsequent transferee who received proceeds of an avoided transaction “for value …, in good faith, and without knowledge of the voidability of the transfer.” 11 U.S.C. § 550(b)(1). What constitutes “knowledge” under the statute is sometimes murky, however, particularly where the subsequent transferee, such as an investor, relied on an agent to make investment-related decisions on the investor’s behalf.
The U.S. Court of Appeals for the Fifth Circuit recently examined this question in In re Black Elk Energy Offshore Operations, LLC, 114 F.4th 343 (5th Cir. 2024). The court affirmed lower court rulings that certain investors who received proceeds of an avoided fraudulent transfer from the initial transferee were not protected by the good-faith defense in section 550(b)(1), because the investors’ agent was aware of, and participated in, the fraud. The agent’s knowledge of the fraud was imputed to the investors, the court determined, even though the agent’s conduct was criminal, and even though the investors maintained they had no personal knowledge of the fraud at the time of the transaction.
Good-Faith Defense to Avoidance of Transfers
The Bankruptcy Code gives a bankruptcy trustee or a chapter 11 debtor-in-possession (“DIP”) the power to avoid (i.e., invalidate) certain pre- and post-bankruptcy transfers of, or incumbrances on, a debtor’s property and to recover such property for the benefit of the debtor’s estate and creditors. For example, section 548(a)(1) of the Bankruptcy Code authorizes a trustee or DIP to avoid a “fraudulent transfer,” defined as any transfer of an interest of the debtor in property or any obligation incurred by the debtor “on or within 2 years before the date of the filing of the petition” if: (i) the transfer was made, or the obligation was incurred, “with actual intent to hinder, delay, or defraud” any creditor; or (ii) the debtor received “less than a reasonably equivalent value in exchange for such transfer or obligation” and was, among other things, insolvent, undercapitalized, or unable to pay its debts as they come due. 11 U.S.C. § 548(a)(1).
Fraudulent transfers also may be avoided by a trustee or DIP under section 544(b) of the Bankruptcy Code, which provides that “the trustee may avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law,” i.e., under state law. 11 U.S.C. § 544(b)(1). Section 550(a) of the Bankruptcy Code provides that, after avoidance of a transfer, the trustee may recover the property transferred or its value from the initial transferee (or the entity for whose benefit such transfer was made) or any “immediate or mediate transferee” of the initial transferee (i.e., a subsequent transferee). 11 U.S.C. § 550(a).
However, the Bankruptcy Code includes certain statutory defenses that, in some circumstances, allow an initial or subsequent transferee who received the proceeds of an avoided transfer “in good faith” to avoid or limit the transferee’s liability. Section 548(c) of the Bankruptcy Code provides a defense to avoidance of a fraudulent transfer for a “good faith” transferee or obligee who gives value in exchange for the transfer or obligation at issue:
Except to the extent that a transfer or obligation voidable under this section is voidable under section 544, 545, or 547 of this title, a transferee or obligee of such a transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation.
11 U.S.C. § 548(c). Section 548(c) provides only a partial defense and is most often invoked by an initial transferee—i.e., one who received proceeds of an avoided transfer directly from the debtor—who cannot take advantage of the more robust defense in section 550(b) of the Bankruptcy Code applicable to subsequent transferees, discussed below.
Unlike an initial transferee, a subsequent transferee—i.e., one who received proceeds of an avoided transaction either from the initial transferee or thereafter from another transferee—may assert a complete, albeit narrow, statutory defense upon the avoidance of a fraudulent transfer or similar transaction. Section 550(b) of the Bankruptcy Code provides that the trustee “may not recover” from a subsequent transferee “that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided.” 11 U.S.C. § 550(b)(1).
“Good faith” is not defined by the Bankruptcy Code. In determining whether it exists, some courts have applied a two-part analysis, examining: (i) whether the transferee was on “inquiry notice” of suspicious facts amounting to “red flags”; and (ii) if so, whether the transferee reasonably followed up with due diligence to determine whether a transaction may not have been bona fide. See, e.g., Horton v. O’Cheskey (In re Am. Hous. Found.), 544 F. App’x 516, 520 (5th Cir. 2013); Christian Bros. High School Endowment v. Bayou No Leverage Fund LLC (In re Bayou Grp., LLC), 439 B.R. 284, 310-13 (S.D.N.Y. 2010).
In a more recent, and frequently cited, case, the U.S. Court of Appeals for the Second Circuit announced a slightly different standard for analyzing whether good faith was present. In Picard v. Citibank, N.A. (In re Bernard L. Madoff Investment Securities LLC), 12 F.4th 171 (2d Cir. 2021), the Second Circuit articulated a three-step inquiry for reviewing a good-faith defense at the pleading stage under both sections 548(c) and 550(b)(1) of the Bankruptcy Code:
First, a court must examine what facts the defendant knew; this is a subjective inquiry and not “a theory of constructive notice.” … Second, a court determines whether these facts put the transferee on inquiry notice of the fraudulent purpose behind a transaction—that is, whether the facts the transferee knew would have led a reasonable person in the transferee’s position to conduct further inquiry into a debtor-transferor’s possible fraud …. Third, once the court has determined that a transferee had been put on inquiry notice, the court must inquire whether “diligent inquiry [by the transferee] would have discovered the fraudulent purpose” of the transfer.